5 Canadian Banks Worth a Look

Although financials in the US and Europe are still on the ropes, Canadian banks are doing well…and even if European financials weaken further, Canadian banks should be in good shape, writes Tom Slee of The Canada Report.

Canadian banks were among the few pillars left relatively unscathed during the worldwide financial crisis. They not only remained reassuringly strong and profitable, they also instilled consumer confidence: a recent PriceWaterhouseCoopers study shows that 85% of Canadians have faith in their banking system.

However, there are a few question marks hanging over the sector. Investors are becoming concerned about personal debt levels and new capital requirements. Analysts are issuing warnings, marking down their earnings forecasts. Is it time to put bank stocks on hold for a while?

I think that the short answer is no, although the banks are certainly facing a few serious challenges. So I am not suggesting a blanket buy recommendation. Some of the major players are likely to mark time. We will have to choose carefully. However, a lot of the so-called concerns are more noise than substance.

Sure, there is a far less favorable backdrop, but the industry’s fundamentals are in excellent shape. Canadian banks are well equipped to solve the looming problems, some of which may never materialize. Let’s take them one at a time.

First, it’s possible that the European banking crisis could deepen and a ripple effect seriously damage Canadian banks, especially Royal Bank (RY), which has the most exposure. This casts a pall over the stocks because of the continuing media coverage.

In fact, it’s a limited threat. Certainly, the banks would sell off if Greece defaults or there is a similar setback, but there would be relatively few Canadian losses.

Our five major banks have a net exposure to Europe of about $110 billion, but $75 billion or so of that involves loans to Germany, Britain, France, and the Netherlands—the low-risk countries. Moreover, the IMF and the European Central Bank provide offsetting safeguards.

Second, it’s argued that Canadian house prices are overheated, especially in Vancouver and Toronto, and the banks, having funded the demand, could incur mortgage losses when the bubble bursts. Here again, we are dealing with a lot of high-profile spin.

It is true that house prices have soared, and Canadian banks are heavily involved. They now hold $270 billion of uninsured residential mortgages and $115 billion of uninsured home equity lines of credit. That is a substantial amount of exposure.

We have to keep in mind, however, that Canadian credit managers are much more conservative than their US counterparts. They put these loans on their books carefully to hold, not repackage and sell.

Just take a look at the numbers: According to the Bank of Canada, the market value of Canadian privately-owned land and buildings is about $3.1 trillion. Mortgages total $1.2 trillion, for a 40.3% loan to value ratio. We are certainly not drowning in real estate debt. Ten years ago, the ratio was about 36%.

As far as the banks are concerned, the $270 billion of mortgages are secured by property worth approximately $500 billion. Analysts estimate that the average loan to value is about 55%, hardly a nail biting, high-risk situation.

Third, the new Basel 3 requirements come into effect next January, and the critics say they are going to require more capital and stunt bank earnings growth. The truth is, only one major Canadian bank, Scotiabank (BNS), fails to already meet the Basel 3 capital needs. Scotia is busy coming up to scratch, and recently filed a $1.65 billion share offering prospectus.

There is no doubt that the new rules will require much more liquidity and could dampen returns on equity. Analysts, however, believe that our banks will soon adapt, realign their services, and continue to generate significant profits.

Finally, and perhaps most important, Canadian consumers are now overloaded with debt. They are likely to retrench, borrow less, and slow domestic banking business. Here, I agree there is some cause for concern, and we have to factor that into our earnings projections.

As a matter of fact, Canadian retail banking revenue growth was already slowing late last year. Interest-rate spreads were declining. Therefore, 2012 profits will be governed by tighter cost controls.

There is still a lot of money to be made. The banks will just have to work harder to earn it.

So much for the more obvious problems: I think they are manageable, and that the industry will surprise us by posting a 7% growth in profits this year. This, coupled with the fact that the stocks are cheap and the yields attractive, makes me mildly bullish on the sector.

As we go to press, the banks are announcing their first-quarter results, which at first glance seem slightly better than expected. Bank of Montreal (BMO), first up, earned $1.42 a share, compared to the $1.36 consensus forecast. Royal did better, posting a profit of $1.25 a share, well ahead of the $1.14 analysts were expecting. National Bank (Toronto: NA) also surprised on the upside, earning $2 a share compared to the $1.82 Street estimate.

Toronto Dominion’s (TD) numbers were a bit of a mixed bag, but bottom line operating profit of $1.86 a share was ahead of the $1.73 forecast (all of these numbers have been adjusted to eliminate non-recurring items). CIBC (CM) also beat estimates, but Scotiabank came up short.

It’s too early to get a handle on these numbers or identify industry trends, but I was particularly encouraged by TD and National’s retail banking growth. Dividend increases from TD, Scotiabank, and Royal—all rather a surprise—reflect management confidence and are a shot in the arm. On the downside, year-over-year performance was disappointing.

I am leaving our earnings forecasts and stock price targets unchanged for the moment. There are bound to be a few bumps on the road as the recovery sputters, but the banks are strong.